A new government has broadened the mandate of the Norwegian sovereign pension fund. Nina Röhrbein assesses the changes

It may be Europe’s largest sovereign wealth fund, but it would be wrong to assume that Norway’s Government Pension Fund Global (GPFG) is above criticism.

Indeed, the €560bn fund was subject to a stinging report by think-tank Re-Define and Norwegian Church Aid earlier this year. The paper, ‘Investing for the Future’, accusses GPFG of over-exposure to the structural and demographic problems faced by developed nations and declares its current investment strategy sub-optimal.

When asked what needs to change, Sony Kapoor, managing director at Re-Define, simply says “a lot.”

Kapoor has previously argued that Norges Bank Investment Management (NBIM), the fund’s manager, needs to expand the permitted investment universe in terms of asset class and geography.

Clearly, he welcomes the announcement by the new centre-right government in October that the fund will adopt a new strategy to include a NOK100bn (€12.4bn) allocation to infrastructure and a commitment to invest in emerging and developing countries.

“Until now, the investment strategy has been far too narrow and did not allow investments in unlisted assets, which for a fund that is structured as an endowment was difficult to comprehend,” he says.

“NBIM had left most developing and emerging economies outside the investment universe, while its asset allocation was heavily biased towards OECD economies. Now, we finally see the fund breaking up with its past.”

The prime recommendation of the Re-Define report was that a new fund, a Global Pension Fund – Growth, be established. Its main goal would be to invest in alternative assets such as agriculture, energy and infrastructure.

But while GPFG’s current investments are spread across the largest asset classes, namely fixed income, equities and real estate, they have also been well diversified within asset classes, according to State Secretary of the Finance Ministry, Hilde Singsaas. The equity holdings of the benchmark index represent an average ownership stake of 1.2% in more than 7,000 companies and it does not hold more than 10% of any one company.

Singsaas says: “The development of the investment strategy is based on seeking to maximise the international purchasing power of the fund’s capital, given a moderate level of risk. Some of the recent developments are a new fixed income benchmark and a new geographical distribution of the equity benchmark. We have also started to build a portfolio of real estate investments.”

At the end of June 2013, around 0.9% of total assets were invested in real estate.

“When assessing the fixed income benchmark we placed particular emphasis on a wider diversification of risk and on simplifying the benchmark index,” adds Singsaas.

The new fixed income benchmark index excludes some sub-segments of government-related, or, securitised bonds. It comprises a government fixed income portion of 70%, which aims to reduce volatility, and a corporate bond portion of 30%, designed to make more of a contribution to the fund’s returns. The country composition of this sub-index is determined by each country’s GDP. A provision was added to the mandate, allowing NBIM to take account of the differences in fiscal strength between countries in the composition of government bond investments.

The corporate fixed income benchmark also includes covered bonds and is based on global market weights. In its latest report, the Finance Ministry proposed that the government fixed income benchmark be expanded to include all currencies approved by the index provider Barclays. The changes entailed a lower proportion of European currencies and a higher proportion of north American and Asian currencies.

 

A need for unlisted assets

But Kapoor says that for an inter-generational fund structured like an endowment, the most sensible benchmark is an absolute benchmark of global average growth. “I doubt that benchmarking to market indices, which definitely are always a subset, makes much sense for GPFG,” he says.

The broad allocation of fixed income to equity, currently 35-40% versus 60%, GPFG is about right, believes Kapoor.

“But the fund definitely needs to move into unlisted assets, particularly in view of its time horizon and fundamental values,” he says. “What looks on the surface like a conservative risk management strategy amounts to a concentrated one-way bet on the future of OECD economies being bright. The fund invests 94% of its portfolio in mature economies, which are at present all exposed to the same systemic risk factors of demographic decline, excessive levels of public and private debt and slowing growth rates.

“To date the fund has had no strategies for true structural diversification and is taking excessive risks, which was reflected in the 23% drop in its value during the crisis. It is completely inappropriate and irrelevant for a fund with a 100-year investment horizon to be using quarterly stock markets or short-term market index volatility as a measure of risk.”

Kapoor attributes the lack of diversification to the difficulty faced by the Norwegian government in saving up to 10% of its GDP every year.

Initially, the government wanted to avoid negative headlines related to underperformance, which is why it decided to invest in a market index. By only investing in OECD economies, the fund also wanted to reduce the political and corporate risk that comes with investing in emerging markets.

“However, today this 15-year old consensus is no longer justifiable – it is fragile,” says Kapoor. “An average annual return of 3.17% since inception is unsatisfactory when compared to the target return of 4%, which is why we called upon the fund to adapt its strategies.”

The new fixed income benchmark and new geographical distribution of the equity investments will immediately lead to an increase in the allocation to emerging markets from around 6% to around 10%. These changes are being phased in now. Investments in emerging markets will increase further as emerging markets grow relative to other markets, according to Singsaas.

“The background for the change in the geographical distribution was new analysis showing that there no longer appears to be a basis for the high concentration of investments in Europe,” continues Singsaas. “We also noted that global production capacity and global financial markets are increasingly located in other parts of the world. We concluded that the relevant starting point for a new geographical distribution of the fund is market weights for the equity portfolio and GDP weights for the fixed income portfolio.”

Kapoor counters that 10% is a drop in the ocean when the fund has exposure to more than 50% of the world’s GDP.

David Smart, global head of sovereign funds and supranationals at Franklin Templeton Investments, agrees that the fund should strategically increase its emerging markets exposure, but says it is a fallacy that developed market companies only have exposure to developed markets. “There is an awful lot of emerging market [exposure] indirectly, particularly in Europe. It is important for institutions to understand what emerging market economic exposure they have in their developed portfolios before they go directly into emerging markets.”

 

Hydrocarbon dependency

Another issue highlighted in the report is a dependency on oil and gas.

Singsaas is convinced GPFG reduces Norway’s dependence on oil and gas, since it separates current accrual from spending and invests petroleum wealth in diversified financial assets. “GPFG’s investments are spread across all industries in all parts of the world, which makes the fund less vulnerable to incidents in specific industries or countries,” she says.

But Kapoor notes that the oil price is on average significantly higher than was expected when the fund was first set up. “Unless something changes drastically, the fund is expected to grow to about $1.5trn [€1.1trn] by 2025, which is more than double its present value. But there is a huge caveat there – Norway seems to have a short-sighted approach to managing risk to excessive exposure to oil and gas. If actions to tackle climate change, for example, raise the price of emissions or limit their quantity, [asset growth] would be much smaller.”

NBIM’s justification is that it manages a diversified portfolio, of which oil, gas and coal account for less than 10%. But that is an inappropriate way of looking at the exposure, according to Kapoor. The fund, he says, is expected to double to $1.5trn by 2025 with most of the expansion coming from the sale of oil and gas. The true exposure of the final portfolio value to oil and gas is thus more than 50%.

“There is absolutely no justification for NBIM to add to this exposure,” he says. “Given the systemic risk factors and the size of the exposure they actively need to seek investments that diversify some of that risk and they have yet to do that. In short, they need to sell all carbon heavy shares.”

 

To split or not to split

Prior to the elections in September, Norway’s Conservative Party – which now forms part of the new centre-right government – announced its policy to split the fund into different entities, including a real estate fund.

“If you were to split [the fund] in some shape or form, ultimately you would be losing certain economies of scale,” says Smart. “The economy of scale argument is important, given that you have to accept that it is impossible to run some of it on a very active basis – and it is therefore market-cap, index-based for a substantial chunk. It is all about economies of scale, it is not about incremental alpha.”

A single real estate fund would face the problem of perpetually falling short of its 5% target, and would face a temptation to rush into overvalued assets for the sake of meeting the strategic benchmark allocation.

“Splitting the fund to induce competition is a silly idea, which has not met the test of the market,” says Kapoor. “As in Sweden, the fund would only end up with higher deadweight cost. Furthermore, splitting up the fund is not necessary because essentially NBIM can undertake all those different functions within the same governance structure as one fund.”

Instead the Re-Define report recommends GPFG to split its assets into two parts – with equity and fixed income holdings on the one hand and infrastructure and private equity investments on the other, albeit not necessarily as different legal entities.

The Finance Ministry says that there are no proposed major changes to the GPFG. Its next report will be out in spring 2014.

Part of the reluctance to address the fund’s strategy to date, according to Kapoor, has been the fear of rocking the boat and challenging the economic consensus.

“There was strong institutional inertia and it was necessary to do something from the outside in order to shake things up,” he says.

Because the new governing political parties were not associated with the original design of the fund, he believes, they have found it easier to come up with new ideas regarding investment strategy. The widely recognised underperformance of the GPFG and the announcement of a review of the fund in the Conservative Party’s election manifesto were catalysts for change.

“In addition, politicians now recognise that the consensus surrounding intergenerational wealth sharing is no longer fragile, which has facilitated a mature debate,” Kapoor concludes. “So, this is as good a chance as ever to take a fresh look.”